What it means
The logic is tax, not death benefits. Investment growth inside a life policy is generally not taxed as it accrues, and death proceeds are usually received tax free, so a dollar invested through BOLI compounds faster than the same dollar in a taxable bond portfolio.
Banks use that extra return to offset the rising cost of employee benefits. Mechanically, the bank pays a single large premium, names itself as owner and beneficiary, and records the cash surrender value as an asset.
Each period the increase in that value flows through the income statement as non-interest income. Consent is required and the covered pool is limited.
Cover is normally bought only on a defined group of directors and senior employees who sign written consent, and many institutions share part of the death benefit with the insured person's family through a split-dollar arrangement. Supervisors treat BOLI as a long-term, illiquid asset and expect discipline around it.
A common expectation is that total holdings stay within roughly a quarter of the bank's capital, with documented analysis of the insurer's credit strength completed before purchase. The catch is flexibility.
Surrendering a policy early can trigger tax on the accumulated gain plus a surrender charge, so BOLI is close to a permanent decision, and the bank also takes on credit exposure to a single insurance carrier for decades.
In practice
Real-world examples.
Example
A community bank with $500,000,000 of assets buys $12,000,000 of BOLI, equal to about 18% of its $67,000,000 of tier 1 capital and comfortably inside the 25% ceiling its board has set.
Example
A bank funds a deferred compensation plan for eight executives whose promised benefits cost roughly $410,000 a year. BOLI income of $460,000 covers the cost with a small margin, so the plan no longer competes with lending for the bank's capital.
Example
An executive covered by a bank's BOLI dies in service and the bank receives a $2,000,000 death benefit. Under the split-dollar agreement $500,000 goes to the family and the bank keeps $2,000,000 - $500,000 = $1,500,000, recorded as non-taxable income.
Formula
Calculation
Tax-equivalent yield = net crediting rate / (1 - marginal tax rate)
A bank holds $25,000,000 of BOLI credited at 3.40% a year, free of tax. Its marginal tax rate is 21%, so the tax-equivalent yield is 0.0340 / (1 - 0.21) = 0.0340 / 0.79 = 0.0430, or 4.30%.
Compare that with a taxable bond portfolio yielding 4.00%. The BOLI produces $25,000,000 x 0.0340 = $850,000 of tax-free income, while the bonds produce $25,000,000 x 0.0400 = $1,000,000 before tax and $1,000,000 x 0.79 = $790,000 after tax.
The BOLI is therefore worth $850,000 - $790,000 = $60,000 more a year in after-tax income, which is the cash value of that 30 basis point gap between 4.30% and 4.00%. Against that the bank should weigh the illiquidity and the decades of exposure to one insurer.Case study
Seen in the real world.
Pinebrook Savings Bank is a fictional lender used here to illustrate how BOLI is bought and lived with. Facing employee health costs rising about 8% a year, it placed $20,000,000 into BOLI on 14 senior staff, all of whom gave written consent, with a portion of each death benefit shared with the employee's family.
In the first full year the policies credited 3.6%, generating $20,000,000 x 0.036 = $720,000 of tax-free income against a combined health and deferred compensation bill of $640,000. The finance committee was pleased enough to consider a second purchase.
Three years later the illustrative bank wanted to fund a small acquisition and discovered it could not treat BOLI as available cash, because surrendering the policies would have cost a surrender charge plus tax on the accumulated gain. Pinebrook raised debt instead and added a standing note to its policy file that BOLI is a permanent allocation of capital, never a liquidity reserve.
Watch out
Common mistakes.
- Thinking the bank is betting on employees dying. The economics come from tax-free investment growth over decades, and the death benefit is a secondary feature.
- Counting BOLI as liquid. Cash surrender value is an asset, but turning it into cash early triggers tax and surrender charges, so it does not belong in a liquidity plan.
- Ignoring carrier credit risk. The bank is relying on one insurer to perform for thirty years or more, which is a concentrated counterparty exposure that deserves its own review.
Questions
People also ask.
Who has to agree to the cover?
The insured employee must give written consent, and cover is normally restricted to directors and senior staff rather than the whole workforce.
What happens if a covered employee leaves the bank?
The policy usually stays in force with the bank as owner and beneficiary, which is permitted in most jurisdictions but is worth confirming before purchase.
How is BOLI income shown in the accounts?
The annual increase in cash surrender value appears as non-interest income, and death proceeds above the carrying value are recorded as a gain.
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